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An Inflationary Catch-22

The perpetual thorn in policymakers’ side during the post-crisis era has been inflation or, more appropriately, a lack thereof.

No matter what central banks have tried, the deflationary impulse has proven to be remarkably stubborn and paradoxically, QE might well have contributed by preventing creative destruction from purging excess capacity.

Japan’s struggle has been particularly amusing to behold. The central bank has even resorted to creating new measures of inflation in a desperate attempt to put a positive spin on harsh economic realities.

Just a little over a week ago, BoJ governor Haruhiko Kuroda said the following about the abysmal situation: “…it’s necessary to achieve 2% inflation in this round of monetary easing to ensure Japan never falls back into deflation.”

Then, four days later, we got this headline from Bloomberg:

KURODA: BOJ CAN’T SAY NO RISK OF RETURNING TO DEFLATION

Still, there’s always “hope”:

(Chart: Citi with my additions)

On Wednesday, we’ll get flash CPI figures out of Europe- analysts are optimistic. Here’s some color from SocGen:

We expect euro area headline inflation to continue to improve for the eighth month in a row and climb to 1.1% yoy, the highest reading since September 2013. The negative drag from the energy component is likely to vanish, as a result of positive base effects from energy prices coupled with a strong rebound in Brent prices. As a consequence, we expect the energy component’s yoy growth rate to return to positive territory for the first time since June 2014. On the food front, we expect the pick-up in EU internal market prices in the last few months to pass through to consumer prices and as a result food prices should increase for the second month in a row. Core inflation, which has been stuck at 0.8% yoy since August this year is unlikely to show any improvement and should remain stable in December, led by stable services and non-energy industrial goods prices. Nevertheless, the improvement observed throughout the various surveys published to date seems to signal improving inflationary pressure in the coming months. Looking ahead, we expect euro area inflation to remain above 1.0% next year, averaging 1.5% in 2017, with the core metric improving slightly to 1.0%.

(Chart: SocGen)

Surging crude prices and expectations for fiscal stimulus out of the US have helped to boost investors’ outlook.

Of course rising inflation can also cause problems and as Citi notes, higher inflation risk is likely to lead to higher rates vol. Here are some interesting passages from a recent note (with my highlights):

As Fed Funds expectations are moving further away from the zero bound, the range of feasible policy outcomes widens. This is reflected in a steep skew surface of front end rates.

Higher inflation risks at this stage of the global growth cycle imply greater monetary policy divergence, which already is evident from a stronger USD and wider spreads between UST rates and sovereign rates of other DM markets. A greater degree of policy divergence is, naturally, a less stable equilibrium. On one hand, stronger USD makes it easier for other DM central banks to normalize rates, with the potential for more taper tantrums down the road. On the other hand, a stronger USD normally causes tighter dollar lending conditions to the EMs, as has been recently highlighted by the BIS, with the potential for credit shocks.

Historically, higher inflation has been associated with higher inflation vol, likely because of nominal price rigidities at low inflation rates. Consistent with this observation, realized volatility of core inflation has returned to historical averages from extremely low levels as core inflation picked up this year. This upward trend in inflation volatility is likely to continue next year.

In addition to these two fundamental factors, we expect the negative feedback loop between volatility/uncertainty and market liquidity to persist. In the last few years higher volatility has been associated with poorer liquidity, measured, for example, by market depth (Figure 4). This likely reflects a feedback loop mechanism where higher vol leads to lower risk appetite, thinner markets and even higher realized vol.

(Chart: Citi)

So nothing to worry about really. Well, other than the possibility that the world remains trapped in the deflationary doldrums in perpetuity (Japanification). And, on the other hand, the possibility that rising inflation and the attendant policy divergence between the Fed and everyone else ends up triggering another VaR shock/bund tantrum scenario by affording other DM central banks more room to unexpectedly raise rates.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice